Jun 2005

HITTING THE TWENTY YEAR SWEETIE SPOT

I was offered a perspective into the minds of UK institutional investors last month. What was revealed was not in any way deplorable, but it did illustrate what we think is a kind of blindness, a blindness that it may be possible for other investors to exploit.

It began with a call from an old broking chum, now working at one of the US bulge bracket investment banks - could I do him a favour? The favour involved helping out one of his colleagues in the bank's corporate finance department. The colleague was about to make a pitch to Cadbury Schweppes' Finance Director in an attempt to win a piece of that company's corporate broking account. What the colleague was looking for was no less than the "bull case" for investing in Cadbury. As he explained, when he called me next day, in order to have any chance of winning the pitch, the bank needs to persuade Cadbury of its profound insight into the company and its valuation (and preferably undervaluation). The problem is, he further explained, that the bank's own Food Manufacturing analyst is publicly bearish of Cadbury (with a current price target of £4.20) and is thus no source of bullish spin, nor much help in establishing the suitability of the bank to act as Cadbury's adviser. Moreover, so far as he, the banker, had been able to ascertain, most leading investment banks are either neutral or bearish on the company (which is true), so there is no third party research to crib. What makes matters worse, he said, all the UK institutions are underweight Cadbury and the only marginal buyers are US "value" houses. In despair he had asked my broking friend whether, from his wide acquaintance with UK based investors, he knew of a genuine bull of the company. Without hesitation, my mate responded -"You need to speak to Train".

Well, it is true, Cadbury is a major holding for Lindsell Train, in fact our largest UK equity position, at c9.0% of our assets, compared to its FT All-Share weighting of 0.8%. And, consistent with this benchmark risk we are taking, we do regard it as the cheapest stock on the market, at least on a "value to quality" basis. Nonetheless, I was rather taken aback to be identified as the only bull in town, but happy to help out, if only to spread the gospel -

As Richard Thornton, legendary founder of GT Management and mentor to many, including me, once advised - "Find a great investment idea; buy as much as you feel comfortable with; buy the same amount again, so that you can no longer sleep at night because of the size of your position and then - TELL EVERYONE ELSE ABOUT IT!!!".

"I'll tell you what we like about Cadbury" I promised, "if you'll summarise what the UK institutions think that there isn't to like". "Well", said the banker, "their bear case is simply stated".

Cadbury operates in a relatively low growth industry. There is no earnings momentum story. Critically, the shares trade at a P/E premium to the FT All-Share and the Food Manufacturing sector. Finally, the shares have done relatively well over the past 12 months, despite the institutions being underweight and the last thing the sector specialists are going to do now is to capitulate and recommend the shares a Pound higher. "It's dull, at best", he summarised.

Now, I'll report to you how I responded, but only if you'll acknowledge, before I start, that I'm not claiming that we have researched Cadbury more deeply than those bearish analysts or that we know more about the company. I can't show you Lindsell Train's five year divisional earnings model for Cadbury. I'm not claiming that we're smart and right and they are retarded and wrong. It is conceivable that we are both right, they from their institutional perspective and we from ours. We could even be wrong - it won't be the first time. However, we do think Cadbury is a wonderful company, that British institutional investors are fortunate to have the opportunity to own a piece of. We believe a shareholding in Cadbury should be positively treasured, in the full sense of - appreciated and coveted as a rare and beautiful asset.

Our starting point is the conviction that the best share to own is the share that you buy today, that at some point in the distant future, let us say twenty years, is worth many, many times what you paid for it and is delivering a dividend income that has significantly outstripped inflation.

The problem about such twenty year paragons, of course, is that they are both rare and hard to identify without the benefit of hindsight. Most of us feel that holding any share for twenty years or even setting out with the intention of holding any share for twenty years, is unacceptably risky and that the attempt to identify candidates is so fraught with uncertainty as to be pointless. And this feeling is well-founded. Twenty years is indeed a long and perilously unpredictable span in the life of any corporation. We've written before about the ephemeral nature of individual companies - how the "here today" of 1984's first ever FTSE 100 Index is the 80.0% "gone tomorrow" of 2005's FTSE 100, a radically different list to that of twenty years ago. How many of today's FTSE will still be constituents in 2025? Will, for example, Amvescap, Bunzl, Cable and Wireless, Capita, Corus, Exel, Friends Provident, Hays, ICI, Man Group, Morrison, Old Mutual, Rentokil, Rexam, Rolls Royce, Royal Sun Alliance, Shire, Tate & Lyle, William Hill or Xstrata be FTSE constituents in five years, let alone twenty years time (to pick just a few members one might have concerns about)?

An investment holding period of twenty years is too long to commit to for many individual companies, because competition and technology-change constantly erode their ability to generate free cash flows and returns above the cost of capital. Indices do well over long periods of time, but that is because they are constantly renewing, with younger companies replacing mature or failing business models, not because the index constituents are each proving great long term investments. The result of this is an illusion, an illusion of corporate stability. As a result, we think investors persistently overvalue the equity of "ordinary" companies and underestimate the risk of bad things happening to them. Bad things happen to mediocre companies almost all the time. We think investors persistently undervalue companies with genuine predictability.

So, what about Cadbury? Well, we know that it is an unusually profitable company, with operating margins for the last ten years averaging over 15.0% and an average Return on Equity for the same period of over 24.0%. We also know that Cadbury's assets, which generate these attractive returns, have exhibited extraordinary durability. Dr Pepper was first formulated in 1885, before Coke and 120 years later, its volumes and cash flows are still growing. The Dairy Milk "megabrand", as Cadbury calls it, was introduced exactly 100 years ago and is today sold in 33 countries worldwide, with annual retail value of $1.0 billion. Bassett's Jelly Babies came to parturition in 1918 and now over 1 billion are consumed every year. Creme Eggs are of more recent provenance, 1971, but over 300 million are laid every year at Bournville (a dubious statistic - our office secretary must eat over 100 million a year on her own). Hall's cough drops were invented in the 1930's and now account for 50.0% of international cough drop sales. This makes the Hall's brand not only the leader of the world medicated confectionary market, with a share of 22.0%, but also the top global sugar confectionary brand, with a 2.0% share - goodness knows how many packs of Halls nestle in the bottom of grandmothers' handbags, alongside the Trebor Extra Strong Mints (established in 1935, owned by Cadbury and the UK's number one sweet brand by size). Back in the 1970's, Dominic Cadbury, then chairman of the family business, made a proud boast - "Schweppes will still be being mixed with gin long after North Sea oil runs out". Of course, here in 2005, those reserves are indeed depleting, encouraging investors to fund speculative surveys for oil as far away as the Aegean Sea. When, periodically, such appraisal wells prove to be dry, those same investors will doubtless console themselves with several stiff Schweppes and Gordons (let's include a Diageo brand in this pantheon of "predictables") - proving Dominic Cadbury's earlier prediction.

The longevity of Cadbury's brands and their proven capacity to generate cash mean that these assets are of very significantly better quality than those of the average UK company and therefore deserve to be valued more highly than the average. It is, in particular, frankly absurd for institutional investors to dismiss Cadbury shares on the grounds they are overvalued compared to the UK Food Manufacturing sector. This is now a sorry group of companies, mainly comprising low margin raw material processors and the manufacturers of "own-label" goods for the supermarkets, in whose pockets they firmly sit. The tragi-comedy of Dairy Crest and Robert Wiseman's battle for the "privilege" to supply milk to the food retailing giants, each slashing the other's margin, is all too familiar. One realises, with a pang, how foolish it was for UK institutions to have sold out Rowntree to Nestle twenty years ago, or, even, more recently, to have allowed the private equity boys get their hands on the cash flows of United Biscuits or Rank Hovis, owners of moderate, if not "Cadbury-quality" brands - assets which will doubtless be sold back into the public markets at a fat profit to the buyout funds.

Northern Foods sells on a prospective P/E of 12.0x, a discount to the market average. Cadbury sells for a prospective 16.0x, a premium to the All-Share and over 30.0% more "expensive" than Northern Foods. But over the last decade Cadbury's EBITDA per share is up 70.0%, while Northern's is down 17.0% - which is going to be "cheap" or "expensive" over the next ten years? We think anyone who answers "Northern" - "knows the price of everything, but the value of nothing".

"One way to think about valuing Cadbury", I told the corporate financier, "is this". Cadbury is one of perhaps only a few dozen quoted UK companies whose predictability of earnings is such that they can reasonably be directly valued against a gilt. Today irredeemable gilts, which we think are the best benchmark against which to value UK equity, offer a "yield to eternity" of 4.4%. This may seem a niggardly reward for the prospect of lending hard-earned Sterling capital to Gordon Brown forever, however it is indisputably the level, set in one of the most efficient capital markets in the world, by rational investors who would doubtless sell if they did not believe this yield offered an adequate protection against long term UK inflation. Of course, one of the few certainties about any gilt is that its coupon will never vary. It won't fall, which is a welcome enough assurance, but it will never increase, whatever the rate of growth of the UK economy or inflation. The 2.5% Consolidated Loan Stock trades at roughly 57p and has "earnings" of 2.5p, giving an "earnings yield" of 4.4% (2.5p/57p=4.4%). Compare this investment proposition with that offered by Cadbury. With Cadbury we have a collection of assets with a proven capacity to generate cash flows, cash flows that ought, at the very least, to maintain their inflation-adjusted value into the distant future and might reasonably be expected to deliver more. Cadbury has earnings in 2005, on the IBES mean estimate, of 34.2p. If Cadbury were valued no better than the same earnings yield as the irredeemable gilt, its shares would trade at £7.77 (34.2p/4.4%=£7.77). However, Cadbury stock does not trade at £7.77, but at £5.45. And, arguably, on this analysis, Cadbury ought to be worth a lot more than £7.77, because its earnings are likely to increase in the future, while those of the gilt will not.

What is this gap between £5.45 and £7.77? It is two things. It is investors' insistence that Cadbury's shares be hampered by a "risk premium" when valued against gilts, to compensate for the possibility of unpleasant surprises. We accept that "average" companies have a propensity to deliver such unpleasant surprises and, indeed, think that the market's "risk premium" may be too low for many such businesses. For Cadbury, we think it tenable to argue that the company's earnings are of higher quality than a gilt's (in the late 19th century, the then Chancellor of the Exchequer actually cut the coupon on this gilt) and that the concept of "risk premium" is therefore misplaced. The gap, of over 40.0%, is also, in our view, the "margin of safety" that a long term investor can enjoy if he makes a commitment to Cadbury equity. It is how we deduce that the 16.0x valuation of Cadbury, which UK institutional investors apparently baulk at, still significantly undervalues the equity.

I heard back from my mate last week. His colleague didn't know yet whether the bank had won the corporate account, but he was already chuffed by the outcome. Apparently, the banker's boss had attended the pitch, at which he pursued a line of analysis similar to ours. The Finance Director was, by all accounts, deeply impressed and confirmed that this was the way that Cadbury thinks about putting a value on its own equity and deplored the "short-termism" of rival analysts. The boss was duly thrilled at his underling being publicly praised by an important prospective client and his career and bonus prospects look excellent, at least for 2005.

How many more Cadburys are out there?

Nick Train
Jun 2005